In January 2018, the Consumer Electronics Show (CES) in Las Vegas showcased the latest gadgetry from global technology companies.

The CES is traditionally dominated by US companies. But this year’s show was notable for the increased presence of Chinese firms.

More than one third of the 4000 exhibitors hailed from China, many of them headquartered in the southern city of Shenzhen, which is fast emerging as a tech hub to rival Silicon Valley. Among the Chinese products on show were virtual-reality devices and smart cars equipped with facial-recognition software.

The CES showed China is becoming a hotbed of innovation – and its ambitions aren’t limited to consumer gadgets. Incentivised by the government‘s ‘Made in China 2025’ initiative, Chinese manufacturers are developing cutting-edge industrial robots and high-speed trains. Internet companies such as Alibaba and Baidu are increasingly blazing a trail in areas where US firms were once pre-eminent – such as artificial intelligence – while ecosystems of go-getting tech start-ups are flourishing in Chinese cities.

“There’s a culture of innovation and entrepreneurship in China which is pretty infectious,” says Professor Erik Brynjolfsson, director of the Massachusetts Institute of Technology (MIT) Initiative on the Digital Economy and an expert on the economics of innovation. He cites a lack of regulatory barriers as a factor in the rise of “permissionless innovation” in China.

So what are the geopolitical and economic implications of China’s innovation boom? And how should investors respond to the shifting balance of power in technology between East and West?

Shock of the new

To understand why the Chinese government is so keen on pushing technological advancement, it is important to grasp the role of innovation in economic growth. Writing in the early 20th century, the Austrian economist Joseph Schumpeter identified five different types of innovation: the introduction of new products; new methods of production; the opening up of new markets; new sources of supply; and new organisational structures. The combination of these factors, he argued, spurs the kind of “creative destruction” that generates rapid economic development.

East Asia has been a crucible of this sort of development over the past half-century. In the post-war years, Japan rose to affluence by targeting investment in education and new technology, and its model was followed by the ‘Tiger Economies’ of South Korea, Taiwan, Hong Kong and Singapore. Starting with basic manufacturing, these countries skilfully shifted towards more value-add sectors as they developed.

China has learned from their example. The country’s rapid development since the ‘reform and opening-up’ period under Deng Xiaoping in the 1980s depended on utilising China’s vast labour force to make products for export to the global market, initially in low-wage sectors such as textiles and latterly in more complex and creative areas.

Internet companies such as Alibaba and Baidu are blazing a trail in areas where US firms were once pre-eminent

Made in China

The Chinese government is keen to capitalise on this progress. Despite its astonishing rise over the past three decades, China still lags behind the US and Western European nations in high-end manufacturing. This provided the motivation behind the ‘Made in China 2025’ plan, officially launched in 2015. Modelled on Germany’s ‘Industry 4.0’, the initiative is designed to kick-start technological innovation in the sector via targeted government investment.

“Made in China is really about upgrading the current manufacturing base,” says Xiaoyu Liu, emerging market equities fund manager at Aviva Investors in London. “As it develops, China risks getting caught in the middle of the value chain between countries that offer low-cost outsourced labour and nations where manufacturing is of better quality, such as the US and Germany.”

China is investing heavily in factories and assembly plants driven by robotic automation, which tends to improve output quality. The government is particularly keen to build an indigenous semiconductor industry to reduce its reliance on importing computer chips, and has earmarked $100-150 billion of public and private funds for this goal.1

Another priority is aerospace, where the government is encouraging domestic firms to cooperate with foreign players to build expertise. In January, the French multinational Airbus agreed to increase assembly operations at a facility in the eastern city of Tianjin, which it runs as a joint venture with the state-owned Aviation Industry Corporation of China (AICC). Airbus will gain increased access to what is now the world’s largest market for commercial aircraft, while AICC will gain knowledge of engine design and engineering methods.

According to some critics, China’s eagerness to engage in ‘knowledge transfer’ with Western firms amounts to a programme of state-sponsored industrial theft. Robert Atkinson, president of the Information Technology and Innovation Foundation, a think tank, told US Congress last year that Made in China is an “aggressive by-hook-or-by-crook strategy that involves serially manipulating the marketplace and wantonly stealing and coercing transfer of American know-how”.2

The Trump administration has ordered a review of China’s intellectual-property practices, which could result in punitive unilateral sanctions under the Section 301 trade authority. Whether or not the charge of theft is warranted, there is some evidence that the Chinese government’s technological investment programme is not simply about improving growth and productivity.

Technology and the state

For investors hoping to identify where the next leap forward in Chinese innovation will happen, it helps to understand the government’s wider objectives. Take one area of industrial technology in which China is becoming a world leader: machine vision. Equipping industrial machines with sensors that can capture and recognise images using artificial intelligence enables companies to automate elements of the production line and fine-tune quality control.

But this technology is also useful in surveillance. Hangzhou-based firm HikVision, a leader in the field of industrial cameras and sensors, is also a specialist in the manufacture of cutting-edge CCTV cameras. HikVision’s biggest shareholder is a Chinese state-owned company, China Electronics Technology Group, which is finding uses for its products in monitoring the populace and spotting early signs of civil unrest – a key priority of Xi Jinping’s government.

“The Chinese state is driving a lot of this innovation,” says Max Burns, senior industrials research analyst at Aviva Investors. “The need to monitor citizens in both public spaces and the internet is driving big growth in AI and facial recognition. HikVision has developed superior facial-recognition software that can identify an unknown face in a crowd and zero in on it. The company has attracted investment from the government as well as a lot of AI automation-focused equity funds.”

Beijing has developed close relationships with China’s trio of internet giants, Baidu, Alibaba and Tencent (the so-called BATs), for similar reasons. Unlike the big technology companies in the West – which have engaged in standoffs with governments over the sharing of user data in recent years – the BATs routinely provide information on customers’ online behaviour to the state, adding to the 42 billion internet records the government collects directly each month.3

This mass of data is facilitating the development of a planned ‘Social Credit System’, which will monitor citizens’ finances, political obedience and supposed civic mindedness. In scenes that might have been devised for the satirical television series Black Mirror, China’s high-speed rail system is already informing passengers that antisocial behaviour may result in a downgrade to their social credit rating.

China is investing heavily in factories and
assembly plants driven by robotic automation

Online-to-offline innovation

But the story of innovation in China is about more than an authoritarian government seeking control over its people. China has invested heavily in high-quality education for its citizens, and now produces 2.8 million science and engineering graduates, five times as many as the US (although the US still leads on a per-capita basis 4).

Technology clusters have emerged around better-quality universities in cities including Guangzhou, Beijing, Shanghai and Hangzhou, as firms seek to snap up the brightest graduates. The BATs are among the companies hiring these graduates on teams developing products and services that rival anything on offer in the West.

Take Tencent’s WeChat app. What started as a simple messaging service now runs more like a comprehensive operating system. Users can book taxis and overseas holidays, make restaurant reservations, play games, pay bills and purchase items at physical shops – all without ever leaving the app. Brynjolfsson cites China as a world leader in this area – what’s known as ‘O2O’ or online-to-offline technology. See Interview with Erik Brynjolfsson.

Tencent’s seamless integration of financial elements into its platform, along with similar innovations from Alibaba and Baidu, has transformed China into the global leader in fintech. These firms have started to move beyond digital payments into insurance, wealth management and peer-to-peer lending; taking advantage of their ability to collect data on potential customers to offer them new products and services.

The BATs are also outperforming in some artificial-intelligence disciplines: Baidu is now the acknowledged leader in speech-recognition technology, for example. When, in October 2016, Microsoft announced its software had surpassed human-level recognition standards, Andrew Ng, then Baidu’s head of research, posted a tongue-in-cheek reminder on Twitter that Baidu had achieved the same feat for the Chinese language a full 12 months earlier.5

The balance of power in technology may be moving to the East, but the US still has a clear lead in many AI specialisms. Google’s development of the AlphaGo programme, which has devised strategies to beat human grandmasters at the Chinese-originated board game Go, is a symbolic reminder that the Silicon Valley heavyweights are still dominant in many areas of AI.

Bonfire of the bicycles

To compare how the US and China measure up on broader innovation metrics is difficult, but we can draw a few broad conclusions. The US spends more on so-called ‘basic and applied’ research and development, which refers to the process of making early discoveries and refining them. This means it still has a clear lead in industries that rely on original breakthroughs, such as pharmaceuticals, where Chinese firms are struggling to build global market share.

Chinese companies, on the other hand, are proving extremely adept at ‘late stage’ development – building on existing discoveries and bringing innovative new products to market, such as those that wheeled and buzzed their way among the crowds at the Las Vegas convention centre in January. More than 84 per cent of Chinese R&D spending goes on late-stage ‘development’ funding, compared with two thirds in the US, according to research from the Boston Consulting Group.6

This is partly because Chinese companies are able to access a vast population of tech-savvy consumers who are comparatively more willing to try out products and services compared with their peers in the West.7 This has given China the upper hand in developing and commercialising consumer-oriented technology such as drone hardware: Shenzhen-based DJI is now the dominant player in the global drone market.

Chinese companies have also benefited from relatively loose regulations around the commercialisation of new products, according to Jason Bohnet, senior research analyst at Aviva Investors in Chicago. “Chinese companies almost have a blank slate to be agile and innovative,” he says. “They can try something new, and say: ‘what’s the worst that can happen’? Because they know that if they make a breakthrough or a solution to a problem they will have no bigger supporter than the Chinese state.”

The cutthroat Chinese bike-sharing industry provides a case study of how this deregulated free-for-all in new tech can turn out; it’s an example of Schumpeter’s ‘creative destruction’ in action. Chinese firms were among the first to develop GPS-powered technology to enable Uber-style bike sharing without the need for docking stations. A plethora of competing companies emerged, flooding the market with bicycles. But many of them quickly went out of business, leaving streets clogged with piles of mangled bikes.8

Investing in Chinese tech

Given the rapid rate of change, it can be difficult for foreign investors to devise strategies to take advantage of the growth of Chinese innovation. But there are opportunities for those who have the requisite local expertise, according to Liu.

“There are big rewards on offer for those who can identify the leaders in these fast growing markets,” she says. “For example, Tencent has delivered an annual return of more than 50 per cent over the past five years and a 43 per cent compound annual growth rate over the past decade. Corporate governance is still an issue with some Chinese technology firms, but these are problems evident in technology companies around the globe.”

Established Chinese technology firms are growing ever more expensive as investment propositions – Alibaba’s share price rose 96 per cent last year – but are not yet in bubble territory, according to Liu. “This is not a technology bubble like the 2000s. Although the valuation of the big internet companies is higher than their historical average, they are backed by strong earnings growth and cash-flow generation. Investors will, however, need to be selective going forward.”

As they grow in clout and influence, the BATs are increasingly shaping the landscape for start-ups, which may help investors determine the likely winners and losers in tyro industries. Mobike and Ofo, two of the firms that survived the boom and bust in the Chinese bike-sharing sector, are financed by Tencent and Alibaba respectively.

The BATs are also becoming influential investors in technology beyond China’s borders: Tencent has taken small stakes in Snap, Spotify and Tesla. “The big Chinese companies have an advantage, in that they can go out and get business outside of China but their foreign rivals can’t come into China because of the government’s restrictions,” says Bohnet.

Despite the rise in valuations among the big internet companies, research suggests that if anything, investors are under-pricing the potential for further innovation – and profit growth – among Chinese firms. A recent UBS analysis of R&D spending and profit growth finds that investors have yet to fully appreciate the scale of China’s progress in tech-oriented sectors, which may lead to a gradual re-rating of the country’s equities over the next five years.9

There remain risks to investing in Chinese technology, not least the potentially unpredictable role of the government, which can swiftly crack down on sectors that were previously unregulated (as happened in fintech in 2016 and 2017) or cut a big player down to size, as when Baidu was reprimanded for carrying unlicensed advertisements for medical treatment on its search engine, causing its share price to fall sharply.10

On the other hand, support from the government can give a boost to companies active in priority areas such as advanced manufacturing, bringing benefits for both domestic and foreign investors able to identify China’s long-term goals. Shares in the aforementioned HikVision, along with specialists in robotic automation such as Shenzhen Inovance Technology and Han’s Laser Technology, are accessible to foreign investors via the domestic A-share market.

The role of government in fostering demand and creating incentives is also evident in the electric car industry. Beijing has ordered state-owned Chinese power companies to speed up the installation of charging stations: as of December 2016, China had 300,000 charging stations, dwarfing the US network, which had just 16,000 points in early 2017.11 This growing infrastructure is facilitating the rise of new companies such as Byton, a Chinese start-up that won headlines at the CES when it unveiled a facial-recognition enabled electric car.

“China has a poor record on pollution, which is a big incentive to go green and to get more electric and autonomous vehicles out there on the road. On a global basis, China sells more electric vehicles than any other country and we expect that to continue for the foreseeable future,” says Bohnet.

If you can’t beat ‘em, join ‘em

So what are the implications of China’s rise for companies in advanced economies? Burns believes industrial and technology-focused firms with strong research and development budgets – such as US multinational manufacturing company 3M, which has increased its spending on innovation to six per cent of revenue in recent years – will have an edge as the battle for innovation intensifies.

Companies with expertise in helping high-end manufacturers make incremental improvements to efficiency and quality – such as Japanese firm Keyence, a specialist in precise, laser-guided automation systems – could also reap dividends as more firms seek to upgrade their facilities to maintain their lead against Chinese rivals.

Over the longer term, however, China’s heavy investment in advanced manufacturing will begin to tell, enabling it to close the gap with the West and even move ahead, in Burns’s view. As the balance of power shifts, investors may start to target firms that are willing and able to join forces with powerful Chinese counterparts in some sectors.

Europe may be stealing a march on the US in this regard. During his state visit to Beijing in January 2018, President Emmanuel Macron sought improved access to the Chinese market for French companies. In the wake of the visit, Airbus confirmed the expansion of its partnership with AICC, while Tencent and French retailer Carrefour also announced an agreement to cooperate on e-commerce platforms.

“That partnership opens up a market Carrefour previously had little access to, and should theoretically help it elevate its growth profile without having to spend billions of euros on building more physical stores in China,” says Bohnet. “It is developing a relationship with a best-in-class franchise in Tencent and levering that.”

The future of innovation

Whether their companies are cooperating or competing, China, Japan and Western countries will have to grapple with the unpredictable consequences of new technological innovations. These advancements are increasingly skewing economies towards the ephemeral forces of the digital world.

China’s distinctive political system is likely to provide both advantages and disadvantages in this respect, according to Jonathan Haskel, professor of economics at Imperial College Business School in London, and co-author of Capitalism Without Capital, a study of how economies are increasingly dominated by ‘intangible assets’ such as design, branding, software and research and development rather than physical things.

“Government investment in the science base might become increasingly important in the intangible economy, because as firms become more intangible-intensive, they will look to the public sector to provide the basic scientific knowledge around which firms can build and commercialise new products,” says Haskel. “So to the extent the Chinese system is centralised, and pushes the science budget ahead, that is to their advantage.”

But Haskel also points out ‘intangible’ assets typically flourish in decentralised economies that favour experimentation and provide robust protections for intellectual property. One quality of intangible assets is that they generate ‘spillovers’ – it is relatively straightforward for another company to copy a new concept or design. This makes it more important for companies to be able to protect their IP. “To the extent IP protections are weak in China, it might mean investment is weaker,” says Haskel.

Chinese companies now make more international patent applications than any other country, and Beijing has introduced new enforcement mechanisms, including specialised IP courts, which should improve companies’ IP protection at home. “Chinese patent protection still lags behind the West, but the situation is improving,” says Liu.

There is certainly no room for complacency among Western firms, which will need to keep innovating to compete with their Chinese rivals. The evidence was there in the air-conditioned conference halls of the CES in Las Vegas, where China demonstrated it is already overcoming its reputation as a land of copycats and knock-offs to become a technological force in its own right. And shiny consumer gadgets are just the beginning.

1 ‘Chips on their shoulders’, The Economist, January 2016

2 ‘China’s push to become a tech superpower has triggered alarms abroad,’ Financial Times, March 2017

11 ‘US now has 16,000 public electric vehicle charging stations with 43,000 connectors’, Electrek, June 2017

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at January 30, 2018. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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China is now the world leader in ‘O2O’, or online-to-offline technology.

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